Placing a Stop-Loss Order In the Market Place

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Let's say you have a $20,000 trading account and have decided to risk no more than 5 % of your trading capital on any single trade. You turn bullish on Soybeans and buy one contract of November Soybeans at a price of $5.00/ bushel. In an attempt to limit your risk on this trade to 5 % of your trading account you decide to place a stop-loss order with your broker. 5% of $20,000 is $1,000. Soybeans trade for $50 a cent. So you can risk a $0.20 move against you. You then call your broker and place an open order (meaning it will-remain in the market place until it is either filled or canceled by you) to sell one November Soybean contract at $4.80/bushel. If Soybeans trade at or below $4.80/bushel, your order will become a market order, meaning you will sell one contract at the current market price.

This brings up an important point. You should be aware that placing a stop-loss order at $4.80 in this example in no way guarantees that your loss will be limited to $1,000. Soybeans can move up or down as much as $0.30 a day at which point it has made a "limit" move. If it rises $0.30 from yesterday's close it cannot trade any higher. If no one is willing to sell a contract the market will remain locked at that price in what is known as a "lock limit" move. So in our example, it is possible for Soybeans to open lock limit down at $4.70, thereby triggering your stop. However, if prices remain lock limit down (i.e. there are no buyers willing to step up) your order would not get filled and you would be sitting with a $1,500 loss, even though you did not want to risk more than $1,000.

Not all markets have "limits." As discussed in Section Two, this is something of a mixed blessing. If you are trading a market that does not have any daily limit then you don't need to worry about a lock limit move against you. On the other hand, there is also no real limit as to how far a market can move against you on any given day.

One disadvantage to placing an open stop order in the market place is the phenomenon that you are certain to experience if you do so. The market you are trading just seems to know where your stop is and trades to or just beyond that price just long enough to stop you out, before merrily resuming the trend that you had anticipated in the first place. If you place open stop-loss orders in the market you had better just get used to this cruel twist of Murphy's Law because it is not an uncommon occurrence.

One other complaint about stop-loss orders espoused by those who say stops should not be used is that they can interfere with the system you are using to trade. For example, say you develop a method for identifying the trend of T-Bond futures. It gives a buy signal so you buy one T-Bond contract. You also place a stop-loss order in the market place. The tricky situation that arises is when your stop-loss price is hit but your system is still bullish. Suddenly, even though you should be long in the market according to your system, you are now flat because your stop-loss order got filled. What to do, what to do?

Despite these potential negatives, placing stop-loss orders in the market does offer one significant benefit. Before discussing that benefit, let's consider the implications of using mental stops or no stops at all.